Management plans and SAS No. 59 going concern resolutions

MANAGEMENT PLANS AND SAS NO .59 GOING CONCERN RESOLUTIONS

Richard Riley, Bruce K. Behn, and Kurt Pany

ABSTRACT

SAS No. 59 states that when auditors believe that substantial doubt exists about aclient's ability to continue as a going concern they should modify their audit reportso as to indicate such doubt. This judgment is based in part upon an assessment ofthe likelihood that management's plans for alleviating identified conditions can beeffectively implemented . Depending upon the effectiveness of these plans, the goingconcern modification may be subsequently resolved in one of the following man-ners : (1) bankruptcy, (2) a continuing going concern modification in the followingyear, or (3) successful resolution through removal of the going concern modificationin the following year. The purpose of this exploratory study is to examine the rela-tionship between management plans and going concern resolutions . We providedescriptive evidence on how frequently specific management plans are cited forcompanies receiving their initial going concern modification, analyze whether thesemanagement plans have been implemented as measured by subsequent managementactions, and examine which specific management actions are associated with theresolution of going concern modifications . Using a one-year planning horizon, wefind that companies not receiving a going concern modification the following year

Advances in Accounting, Volume 17, pages 187-203 .Copyright m 2000 by JAI Press Inc.All rights of reproduction in any form reserved.ISBN: 0-7623-0611-4

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RICHARD RILEY, BRUCE K. BEHN, and KURT PANY

("successful resolution companies") and companies continuing to receive a goingconcern modification implement cited management plans approximately 55 percentand 64 percent of the time, respectively, while bankrupt companies' managementplans implementation rate is only 45 percent . In a multivariate setting, we also findthat management's ability to sell assets, restructure debt, and issue new equity dif-ferentiates successful resolution, continuing going concern modification and bank-rupt companies . Finally, we find that management plan variables provideincremental explanatory power over variables that proxy for SAS No . 59 existingconditions and events, variables identified from prior going concern resolutionresearch.

INTRODUCTION

Statement on Auditing Standards No . 59 (SAS No. 59)(AICPA 1988), "The Audi-tor's Consideration of an Entity's Ability to Continue as a Going Concern,"directs auditors to evaluate whether substantial doubt exists about a company'sability to continue as a going concern . When the results of audit procedures sug-gest that substantial doubt may exist, auditors are required to obtain informationabout management's plans for dealing with the situation and to assess the likeli-hood that such plans can be effectively implemented . When, after consideringmanagement's plans, auditors continue to believe that substantial doubt exists,they modify their audit reports to indicate such doubt . Subsequently, dependingupon the effectiveness of the implementation of management's plans, the goingconcern modification may be resolved in one of the following manners : (1) bank-ruptcy, (2) continuing going concern modification in the subsequent year, or (3)successful resolution through issuance of an audit report with no going concernmodification . The purpose of this exploratory study is to examine the relationshipbetween management plans and going concern resolutions .

In this study we first provide descriptive evidence related to the frequency withwhich auditors and company management cite specific management plans inannual reports coinciding with the receipt of their first going concern modifiedaudit report. Second, we analyze whether these management plans have beenimplemented as measured by subsequent management actions and the resolutionof the going concern modification . Third, we use a multivariate approach toempirically examine the specific management actions associated with the resolu-tion of going concern modifications . To accomplish this, we cross-sectionally testwhether specific management actions are associated with the resolution of goingconcern modifications . As part of these testing procedures, we include variablesidentified in prior literature that were found to be associated with the resolution ofgoing concern modifications to determine which management plan variables addincremental information to uoinn concern resolution models .

Management Plans and SAS No . 59

189

We use a one-year horizon from the date of the financial statements thatreceived a going concern modification because it is consistent with SAS No . 59and because it is the period often suggested by workout/turnaround professionalswho address the need for orderly and expeditious actions to reverse the adverseaffects of financial distress (e .g ., DiNapoli, Sigoloff, and Cushman 1991 ; Freier-muth 1989) . The utilization of a one-year period for empirical tests results in ourthree going concern resolutions in the year subsequent to an initial going concernexplanatory paragraph : (1) bankruptcy, (2) continuing going concern paragraph,or (3) successful resolution of the going concern modification .

This paper proceeds as follows : SAS No . 59 and prior research related to goingconcern explanatory paragraphs are considered in the next section . Data sourcesand sample selection procedures are discussed in the third section . Identificationof management plans and variable development are presented in sections four andfive, respectively . Methodology, results, and sensitivity tests are presented in sec-tion six. Finally, conclusions, limitations and extensions are discussed in the lastsection .

SAS NO. 59 AND PRIOR RESEARCH

SAS No . 59 provides the following going concern evaluation guidelines . First, anauditor should consider existing conditions and events that indicate that substan-tial doubt may exist about an entity's ability to continue as a going concern . If,after considering conditions and events in the aggregate, the auditor believes sub-stantial doubt may exist about the entity's ability to continue as a going concern,the auditor should consider management plans for dealing with the effects of theconditions and events . With regard to management plans, the auditor shouldobtain supporting information and consider whether it is likely the adverse effectsof identified conditions and events will be mitigated and whether managementplans can be effectively implemented . The standard provides four broad areasrelated to management plans that may alleviate a company's financial stress :

(1) plans to dispose of assets ;(2) plans to borrow money or restructure debt;(3) plans to reduce or delay expenditures ;(4) plans to increase ownership equity .

Supporting the emphasis by SAS No . 59 on management plans as an assess-ment tool, Mutchler (1984) suggests that the decision to identify a company as apotential going concern problem should reflect auditors' access to inside informa-tion and management plans such as forecasts, cash flow projections and plannedasset liquidations . Further, several authors note (e .g ., Asare 1990 ; Kida 1980 ;AiIiitrhlar 109r%- Ail„trhlar L7 .,n . ..- .1 0„!1 TR~Yo1 OWM N, ., • •1MV

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explanatory paragraph is likely to occur after extensive negotiations between theauditor and the client company and after much deliberation among audit firm part-ners and managers . Therefore, the going concern explanatory paragraph makes asubstantial statement, not only about a company's current situation, but also aboutits future viability .Management discussions of their plans with auditors are not generally

available. Accordingly, data documenting the association between manage-ment plans and going concern modifications must be obtained indirectly . 1In this study we develop proxies for these management plans by examin-ing publicly disclosed information . We then use this information to deter-mine how successful management was at implementing these proposedplans by examining the management actions that were employed by compa-nies to resolve their financial stress. Finally, we compare specific manage-ment actions associated with companies that subsequently filed forbankruptcy with those of companies for which the going concern modifica-tion was subsequently removed and with those that continued to receive areport modification .

DATA SOURCES AND SAMPLE SELECTIONPROCEDURES

Data Sources

To determine what specific management plans are mentioned in audit reportsand company disclosures, and then to evaluate the outcome of initial goingconcern explanatory paragraphs, we must first identify companies that receivedinitial going concern modifications . To accomplish this task, all AmericanStock Exchange, New York Stock Exchange, and NASDAQ companies thatreceived going concern paragraphs between 1989 and 1992 were identifiedusing CD Disclosure. Predicast's Index of Corporate Change (F&S DataBase), the Wall Street Journal Index, The Bankruptcy Yearbook and Almanac,10-Ks and/or annual reports were examined to identify companies that filed forbankruptcy or were merged, acquired, or liquidated and the dates of thoseactivities . To address this research issue, we also needed the requisite financialdata for our management plan proxies and control variables . The primarysource for numerical data was Compustat industrial, full and research tapes .Annual reports, 10-Ks and/or CD Disclosure were used to gather missing(where available) and qualitative data . Consistent with prior studies, financeand insurance companies (i .e ., SIC codes 6000-6999) and regulated companies(i .e ., SIC codes 4000-4999, except 4200 and 4500) were excluded from thecamnle .


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Sample

During the four-year period, 1989-1992, 276 companies receiving first-timegoing concern modifications were identified, after eliminating financial institu-tions and regulated companies . Of the 276 companies, 141 observations weredeleted for the following reasons :

61

missing data.31

merged or were acquired .3

year-end changes .20

bankrupt prior to an initial going concern .24

going concern paragraphs not applicable to the sample companyor audit report details were not available .

1

voluntary liquidation .1

start-up company .141

The final sample consists of 135 companies categorized by the going concern res-olution in the year subsequent to the initial going concern explanatory paragraphas follows :

36

bankrupt companies . 362

continuing going concern explanatory paragraphs .37

successful resolutions .135

IDENTIFICATION OF MANAGEMENT PLANS

As previously discussed, SAS No . 59 provides four broad areas related tomanagement plans that auditors may use in going concern evaluations . Todetermine which management plans were cited by companies or auditors,we reviewed audit reports and referenced financial statement notes of sam-ple companies in the year of an initial going concern modification for anydescription that related to SAS No . 59's broad areas. We identified a num-ber of different plans which are presented in Table 1 . 4 To facilitate mean-ingful presentation, management plans mentioned infrequently wereincluded in the "other" category . As shown in Table 1, initial going con-cern sample companies cited debt restructuring, issuance of new debt,reducing selling, general and administrative expenses, and sales of assets asthe most common management plans for bringing companies out of theirtroubled circumstances_ The camnie of 115 cnmnaniec PmimeratMrl 9 4 man-

192 RICHARD RILEY, BRUCE K. BEHN, and KURT PANY

Table 1 . Reported Management Plans

Notes: *Percentage is the based on the total number of management plans disclosed .**The variables are described in Table 2 . Variable measurement included in this table is thesummation of individual (dichotomous) company observations . For each company, thevariable is coded 1 if the specific management plan was cited in the audit opinion orrelated financial statement notes in the year of an initial going concern modification .

agement plans on average. Successful resolution companies cited the great-est percentage of plans to restructure debt and reduce employment . In con-trast, bankrupt companies planned the highest percentage of asset sales andcapital expenditure reductions .

VARIABLE DEVELOPMENT

Having identified specific management plans that fall under SAS No .59's broad definitions, the next step is to develop proxies to evaluateempirically whether management has taken actions to implement theseparticular plans and which management actions are associated with goingconcern resolutions . These proxies and their predicted effects are out-lined in Table 2 and brief illustrations of supporting research are pre-sented below .

Management Plans ** Total % Bankrupt %

ContinuingGoing

Concern %SuccessfulResolution %

Sales of Assets 52 16 .7 18 20.2 23 17.1 11 12.7Issuance of New Debt 64 20 .6 16 18.0 31 23 .0 17 19 .6Debt Restructuring 73 23.5 22 24 .7 28 20 .8 23 26 .4SG&A Reductions 54 17.4 13 14.6 28 20 .8 13 14.9Employee Layoffs 19 6.1 4 2.2 7 5 .3 8 9 .2Capital ExpendituresReductionsIssuance of

4 1 .3 2 9.0 1 0 .2 1 1 .1

New Equity 30 9 .6 8 4 .6 14 10 .5 8 9 .2Other 15 4.8 6 6 .7 3 2 .3 6 6 .9Plans CitedNumber of

311 100% 89 100% 135 100% 87 100%

Companies

Average Plans

135 36 62 37

Cited per Company 2.3 2.5 2 .2 2.4


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Table 2. Variable Definitions and Predicted Signs

Variable Name

Predicted Signs Variable Definitions

Sales of

+

Asset sales of property plant equipment and investmentsAssets

from the cash flow statement in the year after an initialgoing concern (yeart+i) less average asset sales in theprior years [((year t_ 1) and (year t ))/2] scaled by beginningof year assets .

Issuance of

+

New debt issuance from the cash flow statement inNew Debt

the year after an initial going concern (yeart+l) lessaverage new debt issued in prior years [((yeart-1)and (year s))/2] scaled by beginning of year assets .

Debt

+

A dichotomous variable, one if a debt restructuring wasRestructuring

completed in the year after an initial going concern(yeart+l), zero otherwise. Debt restructuring is atransaction in which the company's debt contractsare amended on at least one of the following terms :(i) promised interest or principal payments arereduced; (ii) the debt's maturity is extended ;or (iii) creditors are given equity in the company .

SG&A

-

Selling, general and administrative expenses in theReductions

year after an initial going concern (years+,) lessaverage selling, general and administrativeexpenses in prior years [((yeart_ 1 ) and (year s ))/2scaled by beginning of year assets .

Employee

Layoffs equals the average number of employeesLayoffs

in the year after an initial going concern (yeart+l)less the average number of employees in the yearprior to (year t_ 1 ) and year of (year s ) the initialgoing concern [((yeart_1) and (yeart))/2] .

Capital - Capital expenditures from the cash flow statementExpenditures in the year after an initial going concern (yeart+l)Reductions

less average capital expenditures in prior years[((year t_1) and (yeart))/2] scaled by beginning ofyear assets .

Issuance of

+

New equity issuance from the cash flow statement inNew Equity

the year after an initial going concern (year s) less aver-age new equity issuance in prior years [((year t_1 ) and(years))/21 scaled by beginning of year assets .

Plans to Dispose of Assets

Sales of Assets

In addition to SAS No . 59 prescription, prior research (e.g ., Lang, Poulsen, andShip 1 995 ) also cnouects that calPC of nneratina nee tc ceamente nr rl ;v ;c;nnc ara

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frequently used by companies to improve financial condition . The proceeds ofthese sales can be used to repay debt which eliminates the need to extract conces-sions from dispersed creditor groups .

Plans to Borrow Money or Restructure Debt

Issuance of New Debt

In addition to SAS No . 59 guidelines, Chen and Lee (1993) also suggest thatimproving financial structure is an important reaction to financial distress . In cer-tain circumstances, management may be able to convince third party lenders thatwith additional funding the company will be able to overcome current financialstress .

Debt Restructuring

In addition to SAS No . 59 suggestion, prior research has also found that debtrestructuring is an important distress resolution transaction . For example, Gilson,John, and Lang (1990) found that 47 percent of financially distressed companiesavoided bankruptcy by restructuring debt outside the bankruptcy process.

Plans to Reduce or Delay Expenditures

Selling, General and Administrative (SG&A) Expense Reductions

In addition to SAS No . 59 prescription, Asquith, Gertner, and Scharfstein(1994) also found that companies that experience financial distress are likely toreduce discretionary expenditures. We include this variable to capture the extentto which management has reduced its discretionary expenditures . 5

Employee Layoffs

In addition to SAS No. 59 guidelines, D'Aveni (1989) also notes that portionsof companies' workforces may be considered discretionary . Therefore companiescan reduce their variable cash outlays by reducing the number of employees . Ofek(1993) found that employee layoffs were an important determinant of whethercompanies avoided bankruptcy . 6

Capital Expenditure Reductions

In addition to SAS No . 59 suggestion, Asquith, Gertner and Scharfstein (1994)noted a reduction in capital expenditures by companies experiencing financialdistress .

Notes : *Percentage in which management plans were implemented as management actions.**The variables are described in Table 2 . Variable measurement included in numerical fractions

of this table is based on the summation of individual (dichotomous) company observations .The denominator represents the summation of management's cited plans (see Table 1) in theyear of an initial going concern modification . The numerator represents the summation ofcompany's management actions, where companies are coded one if they planned the actionand subsequently initiated management actions related to the specific management plancategory in the year after an initial going concern modification .

Plans to Increase Ownership Equity

Issuance of New Equity

As discussed earlier, Chen and Lee (1993) suggest that improving financialstructure is an important reaction to financial distress . In certain circumstances,management may be able to convince outside equity investors that with an addi-tional capital infusion the company will be able to overcome the current financialstress .

While all these variables are expected to have a positive effect on the compa-nies financial situation, SG&A reductions, employee layoffs, and capital expendi-ture reductions are predicted to have a negative sign in logistic regressionanalyses because the companies are reducing (not increasing) these activities . Allindependent variables are measured as the difference between the year after(year,,,) an initial going concern and the average of the year prior to (year t- 1 ) andthe year of (year.) the initial noine concern exnlanatorv naraeranh . Control vari-

Management Plans and SAS No. 59 195

Table 3 . Management Actions-Implementation Percentages

ManagementContinuing

Going SuccessfulPlans/Actions ** Total %* Bankrupt % Concern % Resolution %

Sales of Assets 37/52 71 .2 11/18 61 .1 20/23 87.0 6/11 54.5Issuance of 39/64 60.9 10/16 62 .5 19/31 61 .3 10/17 58.8New DebtDebt 34/73 46.6 4/22 18 .2 14/28 50 .0 16/23 69.6RestructuringSG&A 25/54 46.3 6/13 46 .2 17/28 60 .7 Z/13 15.4ReductionsEmployee 17/19 89.5 4/4 100 .0 6/7 85 .7 7/8 87 .5LayoffsCapital 4/4 100.0 212 100 .0 1/1 100 .0 1/1 100.0ExpendituresReductionsIssuance of 17/30 56.7 3/8 37.5 9/14 64 .3 5/8 62.5New EquityOther 1/15 7.0 0/6 0 .0 0/3 0 .0 1/6 17 .0

Actions/Plans 174/311 56% 40/89 45% 86/135 64% 48/87 55%

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ables identified from prior research include the following : the change in return onassets (CHGROA), default status (DEFAULT), the current ratio (CACL), thechange in the long-term debt scaled by assets (CHGLTDA) and debt scaled byassets (DEBTA) . 7

TEST RESULTS

Management Actions-Implementation Percentages

To gain insight into how often company management actually implementedtheir plans, we reviewed the company's subsequent year financial statements . Forexample, if a company stated that it was going to dispose of assets in year one, andrecorded asset sales in year two's cash flow statement, this management actionwas coded one as if implemented (and zero if not implemented) . Descriptive sta-tistics comparing management plan implementation rates in the subsequent yearto management plans cited in initial going concern explanatory paragraphs orrelated notes are presented in Table 3 .

Overall, companies receiving an initial going concern modification imple-mented their plans approximately 56 percent of the time. Successful resolutioncompanies have an implementation rate of 55 percent and companies continuingto receive going concern modifications have an implementation rate of 64 per-cent. However, bankrupt companies tend to implement their plans only 45 percentof the time. Noteworthy implementation rate differences were debt restructuring,the ability to issue equity, and reducing selling, general and administrativeexpense. With regard to debt restructuring, successful resolution companies com-pleted a planned debt restructuring 69 .6 percent of the time versus 50 percent forcompanies continuing to receive going concern modifications and 18 .2 percentfor bankrupt companies. Similarly, successful resolution and continuing goingconcern modification companies completed an equity issuance approximately 60percent of the time versus 37 .5 percent for the bankrupt group . Finally, bankruptcompanies reduced selling, general and administrative expenses 46 .2 percent ofthe time versus 60.7 percent for companies continuing to receive going concernmodifications and 15 .4 percent for the successful resolution group .

Management Actions-Implementation Averages

While Table 3 provides descriptive (dichotomous) statistics of whether man-agement plans were implemented through management actions, it does notaddress the actual levels of implementation of those plans in comparison to theprior years. To analyze the level of implementation we compared mean differ-ences between years across the three groups . Univariate statistics for successful

Management Plans and SAS No. 59

197

Table 4. Management Actions-Implementation Averages

Notes: p-values for all variables are one-tailed. Significance :*.*1%, 5%, * 10%

resolution, continuing going concern modification and bankrupt companies arepresented in Table 4 .

The univariate results in Table 4 demonstrate that bankrupt companies have the low-est levels of asset sales, new debt issuances, and debt restructurings . Successful reso-lution companies have the largest amount of asset sales and the most debt restructurings .Continuing going concern companies issue the most new debt . While many of the dif-ferences in levels across the groups are not significant, differences across the variabledebt restructuring are significant in a univariate setting at the .10, .01, and .05 levels .In addition, there is a significant difference (p-value < .05) in asset sales between con-tinuing going concern companies and bankrupt companies .

Based on this univariate analysis companies continuing to receive going concernmodifications reduced selling, general and administrative expense and employeehead counts the most, while bankrupt companies lowered capital expenditures themnet Thuru ora drrn ;finont it ;ff rannac ,n cull ; nn . ..ural o„il o~lm;n ;ctrot; .ru

(1)

Bankrupt

(mean)(std. dev.)

(2)

ContinuingGoingConcern

(mean)(std . dev .)

(3)

SuccessfulResolution

(mean)(std . dev .)

(2) vs (1)

(t-value)(p-value)

(3) vs (1)

(t-value)(p-value)

(3) vs (2)

(t-value)(p-value)

Sales of Assets 0.002 0 .015 0 .020 1 .64 1 .03 0.320.004 0 .048 0 .104 0 .05 ** 0 .15 0 .37

Issuance of 0.034 0 .087 0 .049 1 .02 0 .47 -0 .72New Debt 0.119 0 .301 0 .155 0 .16 0 .32 0 .24

Debt 0.111 0.226 0 .432 1 .41 3 .25 2 .19Restructuring 0.319 0 .422 0 .504 0 .08 * 0 .00 *** 0 .02

**

SG&A -0.027 -0.052 -0 .019 -1 .40 0 .57 1 .91Reductions 0.063 0 .094 0 .054 0 .08 * 0 .29 0 .03

**

Employee -0 .028 -0.038 -0 .014 -0 .34 0 .77 0 .83Layoffs 0 .090 0.174 0 .063 0 .37 0 .22 0 .20

Capital Expen . -0 .012 -0.000 -0 .002 1 .40 0 .89 -1 .19Reductions 0.067 0 .001 0 .012 0 .08 * 0 .19 0 .12

Issuance of 0.013 0 .008 0.047 -0.46 0 .84 1 .29Equity 0.070 0.033 0 .235 0 .32 0 .20 0 .10 *

Total Sample 36 62 37

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Table 5. Multinomial Logit Regressions

Model xZ : 136.1 Pseudo R2 : 47.3%

Notes: p-values for all variables except the constant are one-tailed . Significance: ***1%, * 5%, 10%

expenses between continuing going concern and bankrupt companies (p-value < . 10)and successful resolution and continuing going concern companies (p-value < .05) .These results are not intuitive . These findings may be because these variables includeboth discretionary as well as nondiscretionary items or because, while cutting dis-cretionary expenditures is necessary, expenditure cuts that are too severe negativelyimpact the short-run and long-run health of companies . Finally, successful resolutioncompanies were able to issue the most new equity when compared to continuinggoing concern companies (p-value < .10) .

Management Actions-Multivariate Tests

While the results of the univariate analysis suggest that some management planactivities can be used to differentiate successful resolution, continuing going con-

Bankrupt vs. Continuing GC

Bankrupt vs. Successful Resolution

Pred. Std . Pred . Std.Sign Coefficient Error p-value

Sign Coefficient Error p-value

Constant N/A 1 .786 0 .949 .06*

N/A 3.320 1 .656 .04**Sales of Assets + 6.627 2 .954 .01***

+ 10.295 3 .502 .00***Issuance of + 2.258 2.186 .15

+ 4.231 3 .018 .08*New DebtDebt + 1.614 0.864 .03**

+ 3.574 1 .146 .00***RestructuringSG&A -4.386 3.142 .08* 4.140 6.148 .25ReductionsEmployee 0.512 1 .603 .37 -1 .000 3.318 .38LayoffsCapital Expert . 6 .716 9 .604 .24 1 .504 14.310 .46ReductionsIssuance of + 2.904 1 .695 .04**

+ 3.041 1.388 .01***New EquityCHGROA + 0.717 1 .302 .29

+ 7.074 2.384 .00***DEFAULT 0.079 0 .660 .45 -3 .705 1 .064 .00*CACL -0.207 0 .296 .24 0 .045 0 .436 .46CHGLTDA + 2.450 1 .059 .01

+ 8.965 2 .661 .00***DEBTA -1 .159 0.509 .01 -3 .921 1 .629 .01

Sample Size :

Successful 37

Prediction Accuracy :

Successful 83.8%Continuing 62 Continuing 85.5%Bankrupt 36 Bankrupt 61 .1%Total 135 Overall 78.5%


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cern modification and bankrupt companies, we also evaluate the explanatorypower of management plan variables in a multivariate setting where control vari-ables, reflecting existing conditions and events, are included in the model . Theresults of the multinomial logit analysis using these variables are presented inTables 5 . 8 We use multinomial logit because the procedure allows the comparisonof three (or more) outcomes in one model .The following multinomial logit model is used to test the impact of

management plans :

OUTCOME= ap +a 1 Sales of Assets + a 2 Issuance of New Debt+ a 3 Debt Restructuring + (X4 SG & A Reductions+ a5 Employee Layoffs + a6 Capital Expenditure Reductions

12

+ a7 Issuance of New Equity + Y, aJ Control Variables + E

i=8

The dependent variable (OUTCOME) is coded 0 for bankrupt companies (i .e .,base group), 1 for companies that continue to receive going concern explanatoryparagraphs in subsequent year(s), and 2 for companies successful at having thegoing concern explanatory paragraph removed after one year . The coefficients inthe multinomial logit model measure the relative effect of the management planproxies for successful resolution and continuing going concern modification com-panies versus bankrupt companies (i .e ., the base group) . 9Table 5 displays the results of examining management actions that were dis-

closed as management plans in prior year note disclosures or audit reports . Salesof assets, debt restructuring and issuance of new equity are significant explana-tory variables of bankrupt versus continuing going concern modification and suc-cessful resolution companies . Note that issuance of new debt is marginallysignificant only between bankrupt and successful resolution companies . In addi-tion, some evidence exists that selling, general and administrative expense reduc-tions also differentiate bankrupt from continuing going concern modificationcompanies . As a sensitivity test of these results, companies whose cited condi-tions and events were exclusively nonfinancial in nature (e .g ., work stoppage,legal proceedings, and so forth) were deleted from the sample . The results for thissample of 129 companies are qualitatively similar to those discussed above .

Related to control variables, the change in long-term debt scaled by assets(CHGLTDA) and debt scaled by assets (DEBTA) are significant predictors ofbankrupt versus continuing going concern modification companies . Further, thechange in return on assets (CHGROA), default status (DEFAULT), the change inthe long-term debt scaled by assets (CHGLTDA) and debt scaled by assets(DEBTA) exhibit significant explanatory power between successful resolutioncompanies and comnanies continuing to receive going concern modifications .

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Finally, the explanatory power of the Table 5 model (log-likelihood = -75 .7) issignificantly greater than that of the restricted model which includes only sum-mary financial ratio measures (i .e ., control variables; log-likelihood = -93 .6) atthe 1 percent significance level .

Other Sensitivity Tests

To ensure the results discussed above are robust to alternative specifications,we completed the following additional tests . To determine if the ability of man-agement plans to provide explanatory power is robust to different summary finan-cial statement ratio measures (i .e ., existing conditions and events), we substituteNogler's (1995) and Mutchler's (1985) models for the summary financial state-ment ratio control measures . Nogler's (1995) final model included the followingvariables: the change in liabilities scaled by assets, the change in operatingincome scaled by assets, financial restructuring, default status and the number ofconsecutive going concern opinions . Because we evaluate all companies one-yearafter the initial going concern, this variable would be coded 1 for all companies ;thus, we do not include this variable . In addition, because we have separate prox-ies for debt restructuring, issuance of new debt and issuance of new equity, weexclude Nogler's financial restructuring variable which was coded 1 if the com-pany completed a debt restructuring or issued new debt or equity . Mutchler's(1985) model includes the following variables : cash flow to total liabilities, thecurrent ratio, net worth to total liabilities, long-term liabilities to total assets, totalliabilities to total assets and net income before taxes to sales . Whether Nogler's(1995) or Mutchler's (1985) control variables are substituted, the results are qual-itatively the same as those presented in Tables 5 . Sales of assets, debt restructur-ing, and issuance of new equity continue to be significant explanatory variablesfor bankrupt versus continuing going concern modification companies and suc-cessful resolution companies .

CONCLUSIONS, LIMITATIONS, AND EXTENSIONS

We provide evidence that management actions, based on the implementation ofdisclosed SAS No. 59 management plan information, are associated with differ-ences among companies that subsequently file for bankruptcy, continue to receivea going concern modification and those that no longer receive a going concernmodified report (successful resolution companies) . In addition, our results suggestthat management action variables provide incremental information beyond thatprovided by summary financial statement ratio measures (proxies for conditionsand events). Insights gained from this study contribute to the understanding of thegoing concern resolution process and may assist auditors in ex ante assessmentsof other companies' plans to alleviate financial distress. For example, while SAS


201

No. 59 directs auditors to consider management plans, the standard does not pro-vide guidance on which management plans may be critical for successful resolu-tion . The results suggest that bankrupt companies have the lowest levels of assetssales, new debt issuances and debt restructurings . Successful resolution compa-nies have the largest amount of assets sales and the most debt restructurings, whilecontinuing going concern companies issue the most new debt .

Although the results of this study provide insight regarding the impact of cer-tain management plan proxies in comparison to others, the lack of significantresults for variables such as employee layoffs and capital expenditure reductionsis curious . While these variables appear to have little power to discriminate com-panies' ability to successfully resolve financial distress, they may be importantbecause (1) they provide cash flow to make debt payments and thus improve cred-itor relations and (2) these actions provide important signals to creditors that thecompany is actively working to resolve their financial distress . As predicted, mostcompanies implemented management plan proxies, but the relative levels wereoften similar across bankrupt, continuing going concern modification and suc-cessful resolution companies . Further, we have examined the impact of these vari-ables after only one year, whereas the impact of these variables may manifestthemselves for companies whose resolution period is longer than one year.

This lack of significance related to some variables may be due to naive predic-tions for management plan proxies . In this study management plan proxies areexamined using cross-sectional analyses . It may be that the success of manage-ment plan variables is company-specific . If success is company-specific for somevariables, cross-sectional tests would not exhibit the power necessary to identifysuccesses for every management plan proxy . Therefore, field-based (or firm-spe-cific) research that evaluates management plans in more detail across time wouldsupplement our findings . Further, as noted in the paper, auditors face uncertaintyrelated to companies' abilities to achieve management plans . Thus, research thatexamines audit work papers and incorporates work paper information as a basisfor expectations (versus the average of the year prior to and year of an initialgoing concern in our study) may have more power to discriminate among groups .

Another observation is that while all companies reduced selling, general andadministrative expenses, employee head counts and capital expenditures, therelative levels were inconsistent with SAS No . 59 guidance (i .e ., successfulresolution companies were not the most aggressive in pursuing these activi-ties) . This situation may be because our variables are noisy measures of discre-tionary expenditures . However, also plausible is the explanation that there arelimits to the extent that a company can cut its expenditures and return to finan-cial health . Future research that investigates the limits to which some expendi-tures may be reduced may provide important information to both researchersand practitioners .

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NOTES

1 . The only study that we are aware of that directly investigates management plans and thegoing-concern opinion is a working paper by Behn, Kaplan and Krumweide (1999) . Their paperuses an ex ante approach to determine if management plans are associated with initial going con-cern modifications .

2. Sixteen companies did not report to the SEC in subsequent years . Four companies were miss-ing one entire years' worth of data on Compustat . Fourteen companies had relatively minor amountsof Compustat data missing and missing data were not able to be manually located on microfiche or CDDisclosure. Twenty-seven companies with initial going concerns in CD Disclosure were not availableon the Compustat tapes .

3. The evaluation of management plans and the identification of successful resolution companiesafter one year is consistent with SAS No . 59 guidelines that auditors should consider a one year hori-zon . However, consistent with prior research we classify companies as bankrupt if they petitioned forbankruptcy prior to having the going concern explanatory paragraph removed . Therefore, our sampleof 36 bankrupt companies includes companies that filed for bankruptcy up to 4 years after the initialgoing concern modification . Thirteen of the 36 bankrupt companies filed within one year and 13 morepetitioned for bankruptcy in the second year . We performed univariate tests and found no significantdifferences between the 36 bankrupt companies and those bankrupt after one or two years .

4. While plans cited in audit reports and referenced financial statement note(s) may not reflect allactions planned by the company, these actions may be considered the primary focus of management'sefforts and plans with the highest probability of successfully alleviating financial distress.

5 . One could argue that discretionary expenditures such as advertising and research and develop-ment should be tested individually. However, due to data limitations, the amounts were not alwaysavailable, especially for research and development . Therefore, selling, general and administrativeexpense reductions was examined as a summary proxy for discretionary expense reductions .

6 . The proxy employee layoffs is not scaled by assets because the number of employees is not indollar terms. Scaling this variable by assets introduces artificial variability into the analysis . Selling,general and administrative expense, and employee layoffs are not significantly correlated .

7. For an additional discussion see Nogler (1995) .8. Prior research suggests that size (usually the natural log of assets or sales) is a significant

explanatory variable of going concern resolutions . Note that with the exception of dichotomous vari-ables and employee layoffs, we scale all management plan proxies by assets and all summary financialstatement ratio measures by either assets or current liabilities . Scaling has the econometric effect ofcontrolling for size differences among sample companies .

9 . Based on procedures outlined in Hosmer and Lemeshow (1989), we identified influentialobservations that significantly influenced our multivariate findings . Due to small sample size, it wasnot practical to delete these observations (e.g., Jennings, Simko, and Thompson 1996) . Therefore, wewinsorized extreme observations (e .g ., Schwartz and Soo 1996) . Winsorizing impacted 18 of 1,215data points or approximately 1 .8 percent of the sample .

ACKNOWLEDGMENTS

We would like to thank Susan Ayers, Joe Carcello, Jane Mutchler, Al Nagy, Terry Neal,Jim Wansley, seminar participants at the University of Tennessee, and the Tennessee Soci-ety of CPAs for helpful comments on previous versions of this paper. In addition, we grate-fully acknowledge the financial support provided by the University of Tennessee SARIFFprogram.


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Documents

Management plans and SAS No. 59 going concern resolutions